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Why I'm Buying the McDonald's of Latin America

Paul Chi and I co-manage The Motley Fool's Street Fighter portfolio, looking for cheap, unloved stocks with home run potential. In a recent video, Paul and I shared the one emerging market stock to buy. Today, after some weakness in the stock, I'm making the move and buying that stock for our portfolio.

Read on to find out why I think Arcos Dorados (NYSE: ARCO) , which trades today for around $20, could be worth more than $50 five years from now.

Supersize your portfolio's growthArcos Dorados ("Golden Arches" in Spanish) is the largest franchisee of McDonald's (NYSE: MCD) restaurants in the world. Arcos purchased what was formerly McDonald's Latin American and Caribbean business in 2007 for $698 million and was granted a 20-year agreement (renewable in 10-year increments) to be the exclusive operator and franchisor of McDonald's restaurants in 19 countries and territories in Latin America and the Caribbean. That includes regional heavyweights such as Brazil, Mexico, and Argentina.

Exactly how big is the opportunity? Consider this. McDonald's has more than 14,000 restaurants in the U.S. alone. In all of Latin America, Arcos' total number of stores is just 1,800 and yet, its addressable market is almost twice as big!

McDonald's

Arcos Dorados

Region

United States

Latin America and Caribbean

Population

309 million

576 million

No. of McDonald's restaurants

14,027

1,777

Source: Company filings.

Furthermore, increasing modernization and higher personal incomes in Latin America should lead to higher demand for quality food and convenience. Take Arcos' largest market, Brazil. According to the Brazilian Ministry of Finance, 29 million Brazilians joined the middle class from 2003 to 2009, while the percentage of Brazil's population living in poverty decreased by almost half. What's more, the percentage of households with $5,000 or more in disposable income was higher in Brazil than it was in other major emerging markets, including China and India. It's no wonder Arcos' comparable store sales were up a whopping 16% last quarter.

These enormously positive trends lead me to believe that Arcos' sales growth is poised to accelerate in the years to come. Arcos' management believes that its ultimate restaurant penetration rate could be 2.5 times that of the United States. That's probably a stretch, but on a restaurant basis, it would put Arcos' potential future restaurant count at 35,000, more than McDonald's entire current global footprint. Even if Arcos were to grow to just half of that of McDonald's U.S. operations, we're still talking nearly four times Arcos' current restaurant count. No matter how you slice your french fries, Arcos is poised for some mighty tasty growth in the years to come.

For further evidence of Arcos' sheer upside, check out how Arcos' size and sales growth stack up against other major global restaurant operators:

With so much more room to grow than Starbucks and Yum! Brands -- and a faster growth rate to prove it -- I'm excited about Arcos here.

An easy double from hereI think 10% annual growth in restaurant count along with high single-digit growth in annual comparable store sales -- thanks to higher prices and increased customer traffic from improving economic conditions -- should help Arcos' revenue grow by at least 15% per year over the next five years. I also think Arcos' net profit margin will increase thanks to economies of scale and increased franchising. My model suggests Arcos will be generating annual sales north of $6 billion by the end of 2016 and profits of nearly $700 million. Applying a slightly above-market multiple of 15 to those earnings would Arcos value at around $10 billion, or almost $50 per share in five years, and I think that's being conservative.

At less than 1,800 restaurants and under $5 billion in market value, Arcos is primed for years and decades of market-beating growth. And that's why we're buying it for our portfolio today.

Arcos Dorados is one of my top picks for 2012, but if you're looking for another idea, a few of our top analysts have selected a different stock that they believe is poised for tremendous growth in 2012. Find out which company in our new free report: "The Motley Fool's Top Stock for 2012." Thousands have already requested access and it'll only be available for a limited time. Simply click here -- it's free.

Comments from our Foolish Readers

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I also like ARCO...however management needs to reign in expenses to maintain growth...from looking at the past finiancials it's going to be tough.

Latest Financials:

Currently Operating Expenses (+26.62%) are outpacing Revenue growth (+25.5%) (Food and Paper (+23.91%) & payroll expenses (+27.29%) are killing them! Within about 15% increase in Minimum wage in Brazil for 2012 it's going to be intresting to see what impact this will have on the bottom line.

Not sure if management is doing enought to curtail these increases...can't most of the Food and Paper costs be sourced locally? After speaking with IR, it was a little unclear...love to get your feedback on these issues.

However on a macro issue, Brazil has a lot going for it over the next several years (World Cup, Olympics, booming industry, wage growth)

In addition, wne fundamental difference between going to McD's in US and Europe is that it's considered a retrenchment, ppl have less money and hit cheap fast food. In Latin America it's a LUXURY, you have a little more money to spend you get to pamper yourself with fast food ;)

I also like ARCO...however management needs to reign in expenses to maintain growth...from looking at the past financials it's going to be tough.

Latest Financials:

Currently Operating Expenses (+26.62%) are outpacing Revenue growth (+25.5%) (Food and Paper (+23.91%) & payroll expenses (+27.29%) are killing them! Within about 15% increase in Minimum wage in Brazil for 2012 it's going to be interesting to see what impact this will have on the bottom line.

Not sure if management is doing enough to curtail these increases...can't most of the Food and Paper costs be sourced locally? After speaking with IR, it was a little unclear...love to get your feedback on these issues.

However on a macro issue, Brazil has a lot going for it over the next several years (World Cup, Olympics, booming industry, wage growth)

In addition, one fundamental difference between going to McD's in US and Europe is that it's considered a retrenchment, ppl have less money and hit cheap fast food. In Latin America it's a LUXURY, you have a little more money to spend you get to pamper yourself with fast food ;)

The problem I see with this analysis is that you are comparing the market caps/markets/earnings of McDonald's with a franchisee of McDonald's restaurants.

Despite huge growth, the profits of the franchisee would not necessarily follow the same trajectory as those of McDonald's, as the business model for a franchisee is very different from that of a franchisor.

Even so, why not just buy McDonald's instead? If Arcos does in fact quadruple locations over the next five years, McDonald's stands to gain as much or more as Arcos, plus you would have ownership of the expansion in Asia as well.

All great points. Thanks for checking out the article. And please do check out the Streetfighter portfolio if you have a moment. Some good picks in there I think (hope).

griderX, rising costs are a real problem for ARCO -- a real problem for a lot of restaurant chains at the moment. Fortunately, I do expect ARCO, given it's size and relationship with MCD, will have some pricing power -- on both the supplier and customer level. It won't be that way in the short-term, but I'm very confident ARCO will eventually moves its profit margins from the 3-4% range to the 8-9% range over time, given scale advantages and an eventual leveling out in input costs.

And I agree with you that I think the sheer growth in Brazil and the LA region is not being priced into the stock adequately. As you point out, and I reference briefly, it's not just the store count opportunity, but the idea that more Brazilians and Latin Americans will be wealthier in the years to come and can afford the "luxury" of a MCD outing.

forthewin, you're spot on that ARCO won't follow the same profit trajectory as MCD. After all, ARCO has to send a fairly hefty % of its sales to MCD every year as part of the Master Franchise agreement.

That said, I still think ARCO can get its profit margins closer to the 10% level. That's still far, far less than MCD's, which is routinely in the high-teens (16-18%). If they can do that, and reach my sales/store count expectations, it's a $50 stock (I think) in 5 years.

As for just investing in MCD instead, law of small numbers my friend. I like MCD a lot, but I just think the upside (even risk-adjusted) is higher with ARCO.